What is Preferred Stock

Often, you will hear the term preferred stock in magazines and on the various financial news channels. The media outlets will inform you about recent events and sometimes mention the name preferred shares. Just recently CNBC reported that a sovereign wealth fund helped rescue Citigroup by purchasing a large amount of preferred stock. So just what is preferred stock?

Like common stock preferred stock represents ownership in the issuing corporation. Unlike common stock the owners of preferred stock typically have no voting writes and as such are silent partners. The owners of preferred stock have no voice in the management of the company. However, some companies do grant limited voting rights to preferred shareholders. If the company does grant limited voting rights this will be detailed in the prospectus for the security.

If owners of preferred stock have no say in the management of a company why is it called preferred stock? The preferred portion of the name comes from the fact that a company must pay dividends to preferred shareholders prior to common shareholders. Also, preferred shareholders have priority on a companies assets over common shareholders should the company go bankrupt.

Preferred stock is categorized as an equity security, just like common stock, but has many attributes that are similar to bonds. Just like bonds normal preferred stock pays out dividends, usually quarterly. The dividends are declared by the company’s board of directors but the amount is fixed when the security is first issued. That is to say that the dividend payments will remain fixed for the life of the security. Even though the dividend on normal preferred stock remains fixed the actual yield that that shareholders receive changes with the market price. For instance, if you purchased a “7 percent preferred” at a par value of $100 then it would pay $7. If the market price was to rise you would still receive your $7 but it would no longer represent a 7% yield.

The market forces that affect preferred stock are different than that of common stock. As preferred stock has a fixed dividend rate it is sensitive to interest rate changes. If interest rates rise the yield of preferred stock may no longer be favorable to investors. Subsequently the market price of preferred stock would decrease until it presents a more attractive yield. On the other hand if interest rates fall the market price of preferred shares would increase as it presents an ever more enticing yield.

The market price of preferred stock is also influenced by the financial health of the issuing company. If a company is have financial troubles it may cease dividends to common share holders and preferred share holders alike. Obviously this can have an effect on the price of preferred shares. However, as preferred share holders have priority over common shareholder on the company’s assets the market price of preferred shares is considered fairly stable.

Preferred stock can be a useful addition to any portfolio. It is extremely suitable for investors whom are seeking safety of principal and dependable dividends. Some investors substitute a portion of their bond allocation for preferred stock as it generally pays a higher dividend. If you decide to purchase preferred stock we recommend using an indexed mutual fund or ETF as part of an asset allocation plan.

NOTE: Preferred stock is often issued with a multitude of features. It would be too lengthy to cover all of the features available in this article. In the future expect new articles that detail the various features of preferred stock. If you are investing in an index fund you really don’t have to worry about the features as you will own a sampling of everything.